Commentary on Economics, Information and Human Action

Resiliency comes from more risk of bank failure, not less

In the always-smart-and-interesting City AM paper from London, Anthony Evans makes an important argument that has been overlooked in financial regulation debates: risk of failure is what creates system resilience, and regulation creates brittle monocultures. He writes in the context of last week’s Independent Commission on Banking (ICB) recommendations for creating regulatory divisions between retail banking and investment banking and implementing other structural changes, with the objective of a more resilient financial system. Evans critiques the over-simplified concept of risk that the report employs:

We can’t say that one thing is more risky than another – only that different activities expose people to different types of risk. Bodies like the ICB needs to shift from trying to – impossibly – reduce risk to placing responsibility on those who are choosing between different risks.

For example, ordinary depositors should not be protected from risk – they need to confront it. It can seem counterintuitive, but the genuine threat of bank runs is probably the best disciplinary device to prevent them from happening.

Evans’ argument stems from an assertion that he makes later in his column, that risk cannot be reduced but can only be transferred from one party to another. While I think that assertion is debatable, the important insight from this part of his argument is that resiliency in complex market systems arises from agents having responsibility for losses associated with taking additional risks, in addition to their receiving profits associated with taking additional risks. Breaking that connection among risk, profit, and loss is one of the core causes of the brittleness of the financial system over the past two decades, and the transmission and magnification of those losses.

Evans makes a second important observation: when regulation imposes a higher degree of uniformity in a complex system, it reduces resilience of the overall system by creating separated monocultures:

By making arbitrary decisions about what must stay within fences and what doesn’t, or about the level of equity capital that banks will be required to keep, regulators make banking more homogenous. Banks are already free to set up their own ring fences, and a competitive system would be one where they can experiment with different ones. …

All regulations create clusters of errors – by their nature they harmonise behaviour and therefore increase systemic dangers. Policy efforts need to focus on reducing barriers to exit, making it easier for banks to fail, making the costs of failure more visible and ensuring they fall on those who make bad decisions – bankers, regulators, or even the public.

We see this paradox of control in all forms of economic regulation; in this case in financial regulation, but also in the electricity regulation that is the focus of my attention. Regulators believe that by increasing control, by limiting the range of actions that agents can take in complex systems, they are reducing the risk of bad outcomes. But what they do not realize (or choose to ignore) is, as Evans points out here, that by imposing more top-down centralized control on their actions and interactions, they reduce the incentives of the agents to develop their own forms of individual control based on their local knowledge and their own experimentation. Thus regulation makes this complex system more rigid, more brittle, less resilient, and therefore regulation does not achieve its stated goals.

Note here that I am using the tools and language of complexity science and complexity economics, but you can see in this discussion where moral hazard shows up, where you could talk about the failures of corporate governance (as does Charlie Calomiris), etc. Framing the objective as a resilient system broadens the focus beyond top-down regulation to include the individual, decentralized institutions that can keep dangers from becoming systemic. Thinking about regulation in terms of the locus of control and the consequences of the imposition of control in a complex system is more likely to enable us to incorporate the costs of imposing control into the analysis, and to harness decentralized institutions to enable a more resilient system.